Chapter 1

Auditing
sales and collection cycle

1
the auditor is required to critically examine the
assertions in the financial statements on the basis of
the supporting evidence
see the following Eg.
1)The assertion of the Auditor the asset is
overstated,

Assertion Asset shows high but when you check it

is overstated

Assertion of revenue is overstated, mean that the

company does not sell, but the company says that
sell 2
six general transaction-related audit objectives to
management assertions for classes of transactions are
1)Occurrence—Recorded Transactions Exist,
2)Completeness—Existing Transactions Are
Recorded,
3)Accuracy—Recorded Transactions Are Stated at
the Correct Amounts,
4)Posting and Summarization—Recorded
Transactions Are Properly Included in the Master
Files and Are Correctly Summarized,
5)Classification—Transactions Included in the
Client’s Journals Are Properly Classified and
6)Timing—Transactions Are Recorded on the
Correct Dates 3
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales

the six transaction-related audit objectives.

4
 Auditing
sales and collection cycle

5
6
 Substantive Procedures
Substantive procedures are performed in
order to detect material misstatements
at the assertion level (like; occurrence,
completeness, accuracy, valuation,
existence, rights and control), and
include tests of details of classes of
transactions, account balances and is
closures and substantive procedures.

7
 Analytical Procedures
 Analytical procedures involve comparisons of
recorded amounts to expectations developed
by the auditor.
 analytical procedures involve drawing
conclusions based on expected amounts
calculated by the auditor
 Eg. When you observe the companies sales,
Company’s sales increase, also sales increase,
but CGS decrease. So there is a problem and it
is proved by analytical procedure

8
 Introduction
• Auditors perform both tests of controls and tests of
transactions and balances.
• As a means of securing assurance from the clients
system of control, it is important for the auditors to
know when they should rely extensively on internal
controls and when they should not.
• This chapter studies assessing control risk and
designing tests of controls and substantive tests of
transactions for each of the classes of transactions
and account balances in the sales and collection
cycle
9
Objective of table 14-1 is Describe the business functions and the
related documents and records in the sales and collection cycle

10
This chapter designing tests of controls and
substantive tests of transactions for each of
the five classes of transactions in the sales
and collection cycle, including
1) sales,
2) Cash receipts,
3) sales returns and allowances,
4) write-off of uncollectible accounts
receivable, and
5) bad debt expense 11
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

• CLASSES OF TRANSACTIONS IN THE SALES

AND COLLECTION CYCLE are –
– Sales (cash and sales on account).
– Sales returns and allowances, Charge-off of uncollectible
accounts and Estimate of bad debt expense.
– Cash receipts.

• ACCOUNTS IN THE SALES AND COLLECTION

CYCLE includes-
– Sales.
– A/Receivable.
– Cash in Bank.
– Cash Discounts Taken.
– Allowance for Uncollectible Accounts, and Bad Debt Expense 12
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d
• BUSINESS FUNCTIONS IN THE SALES AND
COLLECTION CYCLE: Includes
Processing customer orders, Granting credit, Shipping goods,
Billing customers, Processing and recording cash receipts,
Processing and recording sales returns and allowances, Writing off
uncollectible accounts receivable, & Providing for bad debts
• Documents and Records IN THE SALES AND COLLECTION
CYCLE: Includes
Customer order, Sales order, Customer order or sales order,
Shipping document, Sales invoice, Sales transaction file, Sales
journal or listing, Accounts receivable master file, Accounts
receivable trial balance, Monthly statement, Remittance advice,
Prelisting of cash receipts, Cash receipts transaction file, Cash
receipts journal or listing, Credit memo, Sales returns and
allowances journal, Uncollectible account, authorization form,
and General journal 13
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

1. Classes of Sales Transaction

Accounts
– Sales
– Accounts receivable
Business Functions
• Processing customer orders, - Customer places an
order using Customer Order document.
– This is often followed by the issuance of Sales Order.
• Granting credit- a properly authorized person must
approve credit to the customer for sales on account.
– Minimizes the possibility of bad debts.
– It may be a programmed approval- based on
preapproved credit limit maintained in a customer
master file. 14
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

1. Classes of Sales Transaction Cont’d

Business functions continued ……..
• Shipping goods
– A point at which most companies recognize sale.
– A shipping document is prepared.
– The shipping document may be a multi-copy bill of lading.
– Update perpetual inventory record.
• Billing customers and recording sales- Billing is a means by which
the customer is informed of the amount due for the goods.
– All shipments should be billed and no shipment should be billed
more than once.
– Billing should consider authorized price, quantity shipped and
other terms.
– Done with multi-copy sales invoice and simultaneously updating
of the sales transaction file, accounts receivable master file, and
15
the general ledger master file for sales and accounts receivable.
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d
1. Classes of Sales Transaction Cont’d…
Documents and Records
• Customer Order- a request for merchandise by a customer.
– It may be received in differing formats.
• Sales Order- used to communicate the description, quantity and
related specification of goods ordered.
– Often used to indicate credit approval and authorization for
shipment.
• Shipping Document- a document prepared to initiate shipment of
goods.
– Prepared in at least in three copies – customer, accounts,
retained or merchandiser
• Sales invoice-a document indicating the description and quantity of
goods sold the price, freight charges, insurance, terms, and other
relevant data.
16
– Prepared in at least three copies.
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

1. Classes of Sales Transaction Cont’d…

Documents and Records Continued …..
• Sales transaction file- a computer generated file that
includes all sales transactions processed by the
accounting system for a period.
– It includes all information entered into the system and
information for each transaction- customer name, date,
amount, account classifications, sales person, and
commission rate.
– The file may include returns and allowances if separate
files are not kept for those transactions.
– The information in this file is used for a variety of records,
listing, or reports- e.g. sales journal, A/R master file, and
transactions for certain account balance or division.
17
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

1. Classes of Sales Transaction Cont’d…

Documents and Records Continued …..
• Sales journal or listing-
– A report generated from the sales transaction file that typically
includes the customer name, date, amount, and
account classification or classifications for each
transaction, such as division or product line.
– It also identifies whether the sale was for cash or credit.
• Accounts receivable master file-
– A file used to record individual sales, cash receipts, and sales
returns and allowances for each customer and to maintain
customer account balances.
– The master file is updated from the sales, sales returns and
allowances, and cash receipts computer transaction files.
– It is also called the A/R subsidiary ledger or sub-ledger 18
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

1. Classes of Sales Transaction Cont’d…

Documents and Records Continued …..

Accounts Receivable trial balance-

–A list of the amounts owed by each
customer at a point in time.
–This is prepared directly from the A/R
master file.
–It is often an aged trial balance.

19
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

1. Classes of Sales Transaction Cont’d…

Documents and Records Continued …..
• Monthly statements-
–A document sent by mail or
electronically to each customer
indicating the beginning balance of
A/R, the amount and due date of each
sale, cash payments received, credit
memos issued, and the ending balance
due.
20
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

2. Classes of CASH RECEIPTS Transaction

Accounts
– Cash in bank (debits from cash receipts)
– Accounts receivable
Business Functions
• Processing and recording cash receipts- includes receiving,
depositing and recording cash- currency & checks.
– The possibility of theft is the most important
concern (both before and after recorded).
– All cash receipts must be deposited intact and
recorded in the cash receipts transaction file.
– Remittance advices are important for this
purpose.
21
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

2. Classes of CASH RECEIPTS Transaction

Documents and Records
• Remittance advice- a document that accompanies
the sales invoice mailed to the customer and can be
returned to the seller with the cash payment.
– If no remittance advices are received the person
opening the mail should prepare it.
– Used to permit the immediate deposit of cash & to
improve control over custody of assets.
• Prelisting of cash receipts- a list prepared when cash
is received by someone who has no responsibility
for recording sales, A/R, or cash and who has no
access to accounting records.
– It is used for verifying whether cash received was
recorded and deposited.
22
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

2. Classes of CASH RECEIPTS Transaction

Documents and Records
• Cash receipts transaction file- a computer
generated file that includes all cash receipts
transactions processed by the accounting system
for a period.
– Used to prepare the cash receipts journal and update
the A/R and general ledger master files.
• Cash receipts journal or listing- a report
generated from the cash receipts transaction file
that includes all transactions for any time period.

23
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

3. Classes of SALES RETURNS AND ALLOWANCES Transaction

Accounts
– Sales returns and allowances
– Accounts receivable
Business Functions
Processing and recording sales returns and allowances
– When a customer is dissatisfied with the goods, the seller often accepts
the returned goods or grants a reduction in the charges.
– It is necessary to issue a Receiving Report and return the goods to store.
– Record the transaction promptly and accurately on the Sales and Returns
Journal & A/R master file.
– As an aid for control & to facilitate recording Credit Memos are issued.
Documents and Records
– Credit memo- a document indicating a reduction in the amount due from a
customer because of returned goods and allowances granted.
– Sales returns and allowances journal- a journal used to record sales
returns and allowances.
– Sales journal can be used instead.
24
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d
4. Classes of Write -OFF OF UNCOLLECTIBLE ACCOUNTS Transaction

Accounts
– Accounts receivable
– Allowance for uncollectible accounts
Business Functions
Writing off uncollectible accounts receivable
– When the company concludes that an amount is no
longer collectible, it must be charged off- e.g. if a
customer becomes bankrupt.
– Necessary adjusting entries are made.
Documents and Records
– Uncollectible account authorization form- a document used initially
to indicate authority to write an account receivable off as uncollectible.
– General journal

25
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d
5. Classes of Bad debt expense Transaction
Accounts
– Bad debt expense
– Allowance for uncollectible accounts
Business Functions
• Providing for bad debts
– The provision should be sufficient to allow for the
current period sales that the company will be unable
to collect in the future.
– Allowance method is used.
Documents and Records
• General journal 26
Business Functions in the Sales & Collection Cycle and Related Documents and Records Cont’d

27
 METHODOLOGY FOR
DESIGNING TESTS OF CONTROLS
AND
SUBSTANTIVE TESTS OF TRANSACTIONS
FOR SALES

28
 SUBSTANTIVE TESTING

• Focuses on financial data

• Involves a detail investigation of specific account
balances and transaction amounts
• Substantive testing involve:
1. Performing substantive tests
2. Evaluating results
3. Issuing auditor’s report

 Substantives are used to express opinion

 TESTS OF CONTROLS

• Aim to determine whether adequate controls are in

place and functioning properly.
• The auditor must assess the quality of the internal
controls by assigning a level for control risk.
• Tests of controls involve
1. Performing tests of controls
2. Evaluating test results
3. Determining degree of reliance on controls
• The degree of reliance on internal controls affect the
nature and extent of substantive testing.
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales

31
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales
1) UNDERSTANDING INTERNAL
CONTROLS- SALES
–Typical approach- Auditor
prepares an internal control
questionnaire, and performs walk-
through tests of sales

32
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales
2) ASSESS PLANNED CONTROL RISK- SALES
• Information obtained in understanding internal control is
used to assess control risk.
• There are four essential steps to this assessment:
– The auditor needs a framework for assessing control risk. The
framework for all classes of transactions is the six transaction
(Occurrence, Completeness, Accuracy, Posting and
Summarization, Classification & Timing) -related audit
objectives.
– Identify the key internal controls and weaknesses for sales.
– Associate the controls and weaknesses identified with the
objectives.
– Assess the control risk for each objective by evaluating the
controls and weaknesses for each objective.
• Step four is critical because it affects the auditor’s decisions
about both tests of controls and substantive tests. It is a
highly subjective decision. 33
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…

The key control Activities for Sales are

1) Adequate separation of duties
2) Proper authorization
3) Adequate documents and records
4) Pre-numbered documents
5) Monthly statements
6) Internal verification procedure
34
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…
The key control Activities for Sales are Cont’d.
1) ADEQUATE SEPARATION OF DUTIES: proper
separation of duties helps to prevent misstatement
due to both errors and frauds
– Sales and Cash receipt separate .(Separate in sales the
people who are in sells does not received in cash,
because they process the sale not record the cash )
– Credit granting function vs. the sales function (to
minimize the sales people tendency to optimize volume
even at the expense of high bad debt write-offs).
– Personnel responsible for doing internal comparisons vs.
those entering the original data. (E.g. comparison of
batch control totals with summary reports and
comparison of A/R master file totals with the GL balance
should be done by someone independent of those who
input sales & cash receipt transactions).
35
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…
The key control Activities for Sales are Cont’d.
2) PROPER AUTHORIZATION
The auditor is concerned about authorization at three key points:
1) Credit must be properly authorized before sales takes
place,
2) Goods should be shipped only after proper authorization,
and
3) Price, including freight and discount, must be properly
Authorized or approved- to ensure sales is billed at the
price set by the company policy (Accuracy & Don’t
under Charge)
The first two controls are meant to prevent the loss of
company assets by ship-ping to fictitious customers or
those who will fail to pay for the goods
36
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…
The key control Activities for Sales are Cont’d.
3) ADEQUATE DOCUMENTS AND RECORDS: may be record
paper or Electronic
– Documents and records used must be adequate.
– Should contain sufficient information.
– Most companies automatically prepare a multi-
copy pre-numbered sales invoice at the time the
customer order received. One copy the credit,
one copy the shipping and one copy the
customer
– Useful for minimizing the chance of failure to bill
the customer if all invoices are accounted for
periodically.
37
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…
The key control Activities for Sales are Cont’d.
4) PRENUMBERED DOCUMENTS
– It help to prevents both the failure to bill and
record sales and the occurrence of duplicate
billings and recordings.
– All should be properly accounted.
Eg.. filing, by a billing clerk of a copy of all
shipping documents in sequential order after each
shipment is billed, with someone else periodically
accounting for all numbers and investigating the
reason for any missing documents.

38
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…
The key control Activities for Sales are Cont’d.
5)MONTHLY STATEMENTS
It is a useful control because it encourages customers to
respond if the balance is incorrectly stated.
These statements should be controlled by persons who
have no responsibility for handling cash or
recording sales or accounts receivable to avoid the
intentional failure to send the statements.
All disagreements about the balance in the account
should be directed to the independent designated
official.

39
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…
The key control Activities for Sales are Cont’d.
6) INTERNAL VERIFICATION PROCEDURE: it can be manual or
computerized
– recording of sales transactions fulfill each of the six
transactions (Occurrence, Completeness, Accuracy,
Posting and Summarization, Classification &
Timing) related audit objectives, a computer
program or an independent person check the
processing and recording of sales. e.g. accounting for
numerical sequence of pre-numbered documents,
– Checking the accuracy of document preparation.
– Reviewing reports for unusual or incorrect items.

40
Substantive Tests of Transactions for Sales Occurrence
Procedures transaction related audit objectives.
Recorded sales exist (occurrence)
For this objective, the auditor is concerned with the
possibility of three types of misstatements.
1) Sales being included in the journals for which no
shipment was made,
2) Sales recorded more than once, and
3) Shipments being made to nonexistent customers
and recorded as sales
Many auditors do substantive tests of transactions for
existence objective depend on where the auditor believes
the misstatements are likely to take place. The test will be
done only if they believe that a control weakness exists.
41
 Substantive Tests of Transactions for Sales Occurrence
cont’d
Procedures transaction related audit objectives.
1) Recorded Sales for which there was No Shipment
– Trace selected entries from the sales journal to make sure
that related copies of the shipping and other supporting
documents exist.
– If the possibility of fictitious duplicate copy of a shipping
document, trace amounts to the perpetual inventory
records.
– Trace the credit in the A/r master file to its source- if
collected or goods returned, there must originally have
been a sale. If credited for bad debt or if the account was
still unpaid, intensive follow-up by examining shipping
docs and customer order docs.
42
Methodology for Designing
Substantive Tests of Controls
Tests of Transactions forand Substantive
Sales Tests of
Occurrence
Transactionscont’d
for Sales Cont’d…

2) Sales Recorded More than Once

– Duplicate sales can be determined by reviewing a
numerically sorted list of recorded sales transactions
for duplicate numbers.
– Also test proper cancellation of shipping documents.
3) Shipment Made to Nonexistent Customers
– Can occur only when the person recording sales is also
in a position to authorize shipments.
– If controls are weak, it is difficult to detect.

43
 Substantive Tests of Transactions for Sales Occurrence
cont’d
Procedures transaction related audit objectives Cont’d…
EXISTING SALES TRANSACTIONS ARE RECORDED
– Normally, substantive test for completeness is less
emphasized.
– But if controls are inadequate, which is likely if the
client does no independent internal tracing from
shipping documents to the sales journal, substantive
testes are necessary:-
• Test for unbilled shipments to trace selected
shipping documents from a file in the shipping
department to related duplicate sales invoices
and the sales journal.
44
 Substantive Tests of Transactions for Sales Occurrence
cont’d
Procedures transaction related audit objectives Cont’d…
• Direction of Testing
–Tracing from source documents to the journals- a
test for omitted transactions- Completeness
Objective…likely starting point could be a shipping
doc…a sample selected and traced to sales
invoices and sales journal.
–Tracing from the journals back to source
documents- a test for nonexistent transactions-
existence objective….likely starting point could be
the journal… a sample of invoice numbers is
selected from the journals and traced to duplicate
sales invoices, shipping docs, and customer orders.
•
45
Substantive Tests of Transactions for Sales ACCURATELY
Sales are accurately recorded-Auditor’s Concern
• Accurate recording of sales - shipping the amount
of goods ordered, accurate billing for the amount
of goods shipped, and accurately recording the
amount billed.
• Typical substantive tests include: Re-computing
information in the accounting records
• Start with entries in the sales journal to compare the
total of selected transactions with A/R master file
entries & duplicate sales invoices.
• Compare prices on the duplicate sales invoices with
an approved price list,

46
Substantive Tests of Transactions for Sales ACCURATELY
Cont’d..
Procedures transaction related audit objectives Cont’d…
Sales are accurately recorded cont’d..
• Compare details listed on the invoices with shipping
records for description, quantity, and customer
identification
– When sales invoices are automatically calculated and
posted by a computer, the auditor may be able to reduce
substantive tests of transactions for the accuracy
objective.
– If the auditor determines that the computer is
programmed accurately and the price list master file is
authorized and correct, detailed invoice calculations can
be reduced or eliminated. In this case, the focus will be
on determining if effective computer controls exist.
47
 Substantive Tests of Transactions for Sales Posting and
Summarization
• SALES TRANSACTIONS ARE PROPERLY INCLUDED IN THE MASTER
FILE AND CORRECTLY SUMMARIZED
– Needed b/se the accuracy of these records
affect’s the client’s ability to collect outstanding
receivables.
– The sales journal must be correctly totaled and
posted to the GL
– Perform clerical accuracy tests such as footing
the journals and tracing the totals and details to
the GL and the master file to check whether
there are misstatements. 48
 Substantive Tests of Transactions for Sales Posting and
Summarization cont’d…
• SALES TRANSACTIONS ARE PROPERLY INCLUDED IN THE MASTER FILE AND
CORRECTLY SUMMARIZED Cont’d…
• The distinction between posting and summarization and
other transaction related audit objectives is that posting and
summarization includes footing journals, master file
records, and ledgers and tracing from one to the other
among these three.
– When footing and comparisons are restricted to these
three records, the process is posting and summarization
– In contrast, accuracy involves determining the monetary
correctness of transactions and comparing amounts b/n
docs or with journals and master file records.
49
 Substantive Tests of Transactions for Sales Classing
• RECORDED SALES ARE PROPERLY CLASSIFIED
– Sales of cash vs. credit sales
– Exclude sales of operating assets such as
machinery
– Use of more than one sales classification…..
Regular, installment…
Substantive Tests of Transactions for Sales Cuttoff
SALES ARE RECORDED ON THE CORRECT DATES
– Sales should be billed and recorded as soon after shipment
takes place as possible to prevent the unintentional
omission of transactions from the records and to make sure
that sales are recorded in the proper period.
– Compare the date on selected bills of lading or other
shipping documents with the date on the related duplicate
sales invoices, the sales journal, and the A/R master file.
50
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales Cont’d…
Procedures transaction related audit objectives Cont’d…
SALES RETURNS AND ALLOWANCES
– The transaction-related audit objectives and the client’s
methods of controlling misstatements are essentially the same
for processing credit memos as those described for sales.But
two important differences:
– Materiality, and
– Emphasis on audit objectives-
– primary emphasis is normally on testing the existence of
recorded transactions as a means of uncovering any diversion
of cash from collection of A/R that has been covered up by a
fictitious sales return or allowance.
Completeness objective is important especially at year-end.
Unrecorded SR/A can be material… overstates net income if
unrecognized.
51
METHODOLOGY FOR DESIGNING TESTS OF
CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR CASH RECEIPTS

52
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for CASH RECEIPTS Cont’d…
• DETERMINE WHETHER CASH RECEIVED WAS
RECORDED
– It is difficult to detect a cash fraud occurred before the
cash is recorded in the cash receipt journal or other
cash listing.
– Internal controls designed to satisfy completeness
objective are important.
– Trace from pre-numbered remittance advices or
prelists of cash receipts to the cash receipt journal and
subsidiary A/r records as a substantive tests of the
recording of the actual cash received… effective only if
a cash register tape or some other prelisting was
prepared at the time cash was received
53
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for CASH RECEIPTS Cont’d…
• PREPARE PROOF OF CASH
– A useful audit procedure to test whether all recorded
cash receipts have been deposited in the bank
account.
– Total cash receipts recorded in the journal vs. actual
deposits made during the month…
– It helps to detect recorded cash receipts that haven’t
been deposited, unrecorded deposits, unrecorded
loans, bank loan deposited directly into the bank
account etc.
– Can not help to detect cash receipts that have not
been recorded in the journals or time lags in making
deposits.
– Performed only when controls are weak.
54
Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for CASH RECEIPTS Cont’d…..
• TEST TO DISCOVER LAPPING OF A/R
– Lapping of A/R is the postponement of entries for the
collection of receivables to conceal (hiding) an existing cash
shortage.
– The defalcation is perpetrated by a person who handles cash
receipts and then enters them into the computer system.
– Involves differing recording the cash receipts from one
customer and covers the shortage with receipts of another.
This in turn is covered from the receipts of a third customer
few days later.
– Prevention…. Separate duties and mandatory vacation policy
for employees who both handle cash and enter cash receipts
into the system.
– Detection… Compare the name, amount, and dates shown
on remittance advices with cash receipts journal entries and
related duplicate deposit slips.
55
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF BALANCES
 METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF BALANCES
The methodology that auditors
follow in designing the appropriate
tests of details of balances for
accounts receivable involves some
major steps summarized in figure
4.4 below.
57
 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Figure 4.4 Methodology for Designing Tests of Details of Balances—
Accounts Receivable

58
 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES
Cont’d ….

These steps and related audit work and

decision involves various audit activities
performed and decisions made in the
evidence planning phase of the audit,
materiality and risk considerations and
tests of controls and substantive tests of
transactions discussed in this chapter of
the material
59
METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES
Cont’d ….
• Deciding the appropriate tests of details of
balances evidence is complicated because it must
be decided on an objective-by-objective basis,
and there are several interactions that affect the
evidence decision.

• For example, the auditor must consider inherent

risk, which may differ by objective, and results of
substantive tests of sales and cash receipts, which
also may vary by objective. The auditor must also
consider the results of tests of controls and the
related control risk assessment.
60
METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES
Cont’d ….
• In designing tests of details of balances for
accounts receivable, it is essential to satisfy each
of the nine balance-related audit objectives.
• Existence
• Completeness
• Accuracy
• Classification
• Cutoff
• Realizable value
• Rights and obligations
• Presentation and disclosure

61
 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Important points on the Designing Tests of Details of Balances (figure ) are discussed below.

Steps in Designing Tests of Details of Balances— Accounts Receivable

62
 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances
1) Identify Client Business Risks Affecting Accounts
Receivable
Tests of A/R are based on auditors understanding of
the client’s business and industry.
As part of this understanding,
• The auditor studies the client’s industry and external
environment and evaluates management objectives and business
processes to identify significant business risks that could affect
the FSs including A/Rs
• Perform preliminary analytical procedures that may indicate
increased risk of misstatement in A/R.
Client’s business risk affecting A/R is considered in the
auditor’s evaluation of inherent risk and planned evidence
for A/R
63
 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….

Steps in Designing Tests of Details of Balances…..

2) Set Tolerable Misstatement and Assess Inherent Risk for
Accounts Receivable
– Set preliminary judgment about materiality set for the entire FS
and then allocated to each significant balance sheet accounts,
including A/R… Tolerable Misstatement
– A/R is one of the most material accounts in the FS for
companies that sell on credit.
– Inherent risk is assessed for each objective for an account such
as A/R considering the client’s business risk and the nature of
the client and industry.
– For most audits, inherent risk for A/R is moderate or low
except for two objectives:
• A/R is stated at net realizable value- due to judgment involved &
intentional misstatement and
• Sales and sales return & allowance cutoff is correct- due to possibility of
misstatement.

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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
3) Assess Control Risk for Sales and Collection Cycle
• As a means to good relations with customers, mgt is
concerned with keeping accurate records….hence may
have good internal control over sales & cash receipts &
A/R
 Areas of concern:
– Controls that prevent or detect defalcations
– Controls over cutoff, and
– Controls related to allowance for uncollectible accounts (e.g.
approval of credit before shipment)
 The auditor must relate control risk for transaction-
related audit objective to balance-related audit objectives
in deciding planned detection risk and planned evidence
for tests of details of balances.

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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• Example: Assume that the auditor concluded that
control risk for both sales and cash receipts
transactions is low for the accuracy transaction-
related audit objective. The auditor can therefore
conclude that controls for the accuracy balance-
related audit objectives for A/R are effective b/se
the only transactions affecting A/R are sales and
cash receipts.

• If sales return and allowances & charge-off of

uncollectible A/R are significant, assessed CR must
also be considered for these classes of transactions.
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• Important point on the relationships:
– For sales, the existence transaction-related audit
objective affects the existence balance-related audit
objective, but for cash receipts the existence transaction-
related audit objective affects the completeness balance-
related audit objective.
– Three A/R balance-related audit objectives are not
affected by assessed control risk for classes of
transaction--- Realizable value, Rights & Presentation and
disclosure.
– To reduce assessed control risk below maximum for
these three objectives, separate controls are identified
and tested.

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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
4) Design and Perform Tests of Controls and
Substantive Tests of Transactions
– The results of the tests of controls determine
whether assessed control risk for sales and
cash receipts needs to be revised.
– The results of the substantive tests of
transactions are used to determine the extent
to which planned detection risk is satisfied for
each accounts receivable balance-related audit
objective
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
5) Design and Perform Analytical Procedures for
accounts receivable balance
– Most analytical procedures (AP) performed
during the detailed testing phase are done after
the balance sheet date but before tests of
details of balances --- since all the transactions
are to be in the record.
– APs are done for the entire sales and collection
cycle, not only for A/R.---due to close r/n ship
among accounts.
– When APs in the sales and collection cycle
uncover unusual fluctuations, the auditor should
make additional inquiries of management.
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
5) Design and Perform Analytical Procedures for
accounts receivable balance Cont’d…
– Mgt’s response should be critically evaluated for
adequacy of the explanation and whether they
are supported by other corroborative evidence.
– In addition to APs,
– Review A/R for large and unusual amounts
– Individual receivables that deserve special
attention are large balances, accounts that have
been outstanding for a long time, receivables
from affiliated companies, officers, directors,
and other related parties, and creditors.
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
5) Design and Perform Analytical Procedures for accounts receivable balance
Cont’d…

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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
5) Design and Perform Analytical Procedures for accounts receivable balance
Cont’d…

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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
Compare:
– Gross margin percentage with previous years
– Sales by month over time
– Sales returns and allowances as a percentage of gross sales with
previous years (by product line)
– Individual customer balances over a stated amount with previous
years
– Bad debt expense as a percentage of gross sales with previous years
– Days that accounts receivable are outstanding with previous years
– Aging category as a percentage of receivables with previous years
– Allowance for uncollectible accounts as a percentage of accounts
receivable with previous years
– Charge-off of uncollectible accounts as a percentage of total
accounts receivable with previous years
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
6) Design And Perform Tests Of Details Of Accounts
Receivable Balance
– Tests of details of balances for all cycles are directed to
balance sheet accounts, but income statement
accounts are not ignored because they are verified as
a by-product of the balance sheet accounts.
– For designing tests of details of balances, the auditor
needs to decide on planned detection risk.
– Basically, this decision is a result of combined
consideration of various factors such as the acceptable
audit risk, inherent risk, control risk, substantive tests
of transactions and analytical procedures decision
made until this phase of the audit.
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
6) Design And Perform Tests Of Details Of Accounts
Receivable Balance
– Planned detection risk for each objective is,
finally, an auditor decision, decided by
subjectively combining the conclusions reached
about each of the factors.
– Audit procedures selected and their sample size
depends heavily on whether planned evidence
for a given objective is low, medium, or high.
– Confirmation of A/R is the most important test
of details of A/R. 75
 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• Accounts Receivable Are Correctly Added And Agree With
The Master File And The General Ledger
– An aged trial balance is a listing of the balances in the A/R master
file at balance sheet date.
– Test information on the aged trial balance for a detail tie-in.
– Test information on the aged trial balance must done before any
other tests to assure the auditor that the population being tested
agrees with the GL and A/R master file.
– Must be test footed, and total on the trial balance be compared
with the GL.
– Trace individual balances to supporting documents such as sales
invoices to verify customer’s name, balance, and proper aging.
– Sample size depends on No. of a/cs, degree of tests done in
previous phases of the audit, degree of independent verification.
– Audit software can be helpful- footing, cross-footing, &
recalculating the aging.

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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• Recorded Accounts Receivable Exist
– Confirmation is the most important test of details of balances.
– If no customer response, examine supporting documents to
verify the shipment of goods and evidence of subsequent cash
collection--- Alternative evidence for non-response.
• Existing Accounts Receivable Are Included
– Difficult to test account balance omitted from the aged trial
balance unless comparison with the controlling account (GL)
reveals it.
– If all sales to a customer are omitted from the sales journal,
the understatement of A/R is almost impossible to uncover by
tests of details of balances.
– The understatement of sales and A/R is best uncovered by
substantive tests of transactions for shipments made but not
recorded and by analytical procedures.
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• Accounts Receivable Are Accurate
– Confirm selected accounts.
– For non-responses perform alternative procedures.
– Test debits and credits to individual customer’s balances by
examining supporting documents for shipment and cash
receipts.
• Accounts Receivable Are Properly Classified
– Review the aged trial balance for material receivables from
affiliates, officers, directors, and other related parties.
– Review for any nontrade receivables.
– Ensure that notes receivables or accounts that should not be
classified as current asset are segregated from the regular
accounts.
– If credit balances in A/R are significant, reclassify it as accounts
payable.
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• Cutoff For Accounts Receivable Is Correct
– Cutoff misstatements exist when current period transactions
are recorded in the subsequent period or subsequent period
transactions are recorded in the current period.
– Objective of the test is to verify whether transactions near the
end of the accounting period are recorded in the proper period.
– Cutoff errors affect current period income.
– In determining appropriate cutoff
a) Decide on the appropriate criteria for cutoff
b) Evaluate whether the client has established adequate
procedures to ensure a reasonable cutoff, and
c) Test whether a reasonable cutoff was obtained.
– Sales Cutoff
– Sales Return and Allowance Cutoff
– Cash Receipts Cutoff
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METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
Accounts Receivable Is Stated At Realizable Value
– The auditor should evaluate whether the allowance is
reasonable.
– For evaluation, they prepare an audit schedule that
analyses the allowance for uncollectible accounts.
– Start with review of the results of the tests of
controls that are concerned with the client’s credit
policy.
– If the policy is unchanged and results of the tests of
the credit policy and credit approval are consistent
with the preceding year, the change in the balance
must reflect only changes in economic conditions and
sales volume.
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METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
Accounts Receivable Is Stated At Realizable Value
– Carefully examine the noncurrent accounts on the
aged trial balance to determine which ones haven’t
been paid subsequent to balance sheet date.
– Then, compare the size and age of unpaid balances
with similar information from previous years to
evaluate whether the amount of noncurrent
receivable is increasing or decreasing over time.
– Examination of credit files.
– Discussion with the credit manager.
– Review of the client’s correspondence files.
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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• The Client Has Rights to Accounts Receivable
– To uncover instances in which the client has limited
rights to receivables (as a result of pledging,
assignment, factoring, discounting…), auditors,
– Review minutes.
– Discuss with the client.
– Confirm with the bank.
– Examine debt contracts for evidence of A/R pledged
as collateral, and
– Examine correspondence files.

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 METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES Cont’d ….
Steps in Designing Tests of Details of Balances ……
• Accounts Receivable Presentation and
Disclosures Are Proper
– The auditor must decide whether the client has
properly combined the amounts and disclosed related
party information in the statements.
– To evaluate adequacy of presentation and disclosure,
auditors need thorough understanding of IFRS.
– Decide whether material amounts requiring separate
disclosure have actually been separated.
• E.g. receivable from officers and affiliated companies
– Evaluate adequacy of the footnotes.
• E.g. information about pledging, discounting, factoring,
assignment of A/R, and amount due from related parties.
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 CONFIRMATION OF ACCOUNTS RECEIVABLE BALANCE
• Primary audit procedure for testing existence, accuracy and cutoff.
• Addresses 5 of the 8 balance-related audit objectives (not
classification, realizable value, and presentation & disclosure).
• Expensive audit procedure – auditor and client time – but highly
reliable evidence.
• Required procedure in normal circumstances.
Exceptions to Sending A/R Confirmations
– Accounts receivable are immaterial.
– The auditor considers confirmations ineffective evidence because
response rates will likely be inadequate or unreliable.
– The combined level of inherent risk and control risk is low and
other substantive evidence can be accumulated to provide
sufficient evidence.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE BALANCE…….

Type of Confirmation
• Positive confirmation – confirm the printed
balance on the confirmation.
• Blank confirmation form – requests customer
to fill in balance amount on the confirmation.
• Invoice confirmation – confirm one or more
invoices instead of the total balance.
• Negative confirmation – respond only if
balance is incorrect.
Timing
• The most reliable evidence from confirmations is
obtained when they are sent as close to the balance
sheet date as possible, as opposed to confirming the
accounts several months before year-end.
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 CONFIRMATION OF ACCOUNTS RECEIVABLE BALANCE Cont’d…

Sample Size
– Factors affecting sample size includes:
– Tolerable misstatement
– Inherent risk
– Control risk
– Achieved detection risk from other substantive tests
– Type of confirmation
Selection of Items for Testing
– Stratification is desirable – based on dollar/birr amount or length of time
outstanding. But a sample is also needed for judging total population.
– When selecting a sample of accounts receivable for confirmation, the auditor should
be careful to avoid being influenced by the client.
– If a client tries to discourage the auditor from sending confirmation to certain
customers, the auditor should consider the possibility that the client is attempting
to conceal fictitious or known misstatements of accounts receivable.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
BALANCE Cont’d…
Evaluating Returned Confirmations
– Clean responses – no follow up required.
– Responses with disagreement – follow up with the client for
reason. Reasons could be timing issues, customer can’t confirm
(or won’t), or errors. Customer completes the confirmation
weeks after the cutoff date and their system does not allow
them to go back to the cutoff date to accurately confirm.
– No response – send a second request, do follow up procedures –
subsequent receipts testing
Subsequent Cash Receipts
– Evidence of the receipt of cash subsequent to the confirmation
date includes examining remittance advices, entries in the cash
receipts records, or perhaps even subsequent credits in the
accounts receivable master files.
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– If customer paid for the goods, then the sale must exist.
 CONFIRMATION OF ACCOUNTS RECEIVABLE
BALANCE Cont’d…
Duplicate Sales Invoices
– These are useful in verifying the actual issuance of a sales invoice and the
actual date of the billing.
– If a sales invoice was issued to a customer, then the sale most likely exists.
Shipping Documents
– These are important in establishing whether the shipment was actually
made and as a test of cutoff.

Correspondence with the Client

– Usually, the auditor does not need to review correspondence as a part of
alternative procedures, but correspondence can be used to disclose
disputed and questionable receivables not uncovered by other means.
Drawing Conclusions
– Reevaluate internal control.
– Evaluate the qualitative nature of misstatements.
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– Determine whether sufficient evidence was obtained.
 Essential terms
 Business functions for the sales and collection cycle—the key
activities that an organization must complete to execute and
record business transactions for sales, cash receipts, sales returns
and allowances, write-off of uncollectible accounts, and bad debt
expense
 Classes of transactions in the sales and collection cycle—the
categories of trans-actions for the sales and collection cycle in a
typical company: sales, cash receipts, sales returns and allowances,
write-off of uncollectible accounts, and bad debt expense
 Design format audit program—the audit procedures resulting
from the auditor’s decisions about the appropriate audit
procedures for each audit objective; this audit program is used to
prepare a performance format audit program

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 Essential terms
 Direction of tests—the starting point for testing the
occurrence and completeness transaction-related audit
objectives; vouching from journals to source documents
tests for occurrence and tracing from source documents
to journals tests for completeness
 Lapping of accounts receivable—the postponement of
entries for the collection of receivables to conceal(hiding)
an existing cash shortage
 Performance format audit program—the audit
procedures for a class of trans-actions organized in the
format in which they will be performed; this audit
program is prepared from a design format audit pro-gram

90
 Essential terms
 Proof of cash receipts—an audit procedure to test
whether all recorded cash receipts have been
deposited in the bank ac-count by reconciling the total
cash receipts recorded in the cash receipts journal for
a given period with the actual deposits made to the
bank
 Sales and collection cycle—involves the decisions
and processes necessary for the transfer of the
ownership of goods and services to customers after
they are made available for sale; it begins with a
request by a customer and ends with the conversion of
material or service into an account receivable, and
ultimately into cash 91
End of this Unit

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